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An Economic Early Warning System For Arkansas

"Even before Sept. 11, the interior South--stretching from Alabama to Mississippi, Arkansas and Louisiana and up through Tennessee and Kentucky--was mired in its worst downturn in almost two decades."

(New York Times, Nov. 13, 2001)

Arkansas executive branch officials have consistently underestimated the severity of the unfolding economic recession. Republican Gov. Mike Huckabee and the Department of Finance and Administration offered rosy forecasts for the economy for much of 2001, and today face a fiscal crisis not seen in Arkansas in decades.

Caught by surprise they have been forced to cut $142 million in spending from the state's discretionary budget.

"It's obviously going to be worse than what we originally forecasted," DFA Director Dick Barclay said (Arkansas Democrat-Gazette, Oct. 3). DFA says Arkansas has never faced an economic crisis quite like this year's (Oct. 19). Gov. Huckabee told the Donrey News Service (Nov. 7) state budget cuts "could get nasty."

The Arkansas Policy Foundation warned Gov. Huckabee on Feb. 1 the U.S. economy faced recession and told him tax cuts (fiscal policy) were a proper response. Our advice was ignored by the Huckabee administration yet some of those budget cuts are now occurring, a pyrrhic victory for fiscal conservatives.

Key lawmakers like Senate President Pro-Tem Mike Beebe, D-Searcy, suggested smaller spending hikes earlier this year, noting signs of slower revenue growth appeared last fall during legislative budget hearings (Democrat-Gazette, Oct. 12). Legislative leaders like Sen. Beebe have offered a sober and more realistic view than the executive branch throughout the year. The legislative branch is now in a position to serve the people of Arkansas and plan better for the future by creating an economic early warning system with a high degree of accuracy in forecasting recession. Establishing such a system would make Arkansas a leader among states in the region.

 Ignored By DFA

Two powerful forecasting tools available for free in  the public domain have accurately forecast all seven recessions, including the current economic downturn, dating to 1960. These are the yield curve for treasuries, studied extensively by the Federal Reserve; and industrial production data maintained by the Fed's Board of Governors. DFA does not formally recognize either indicator.

Inversion of the yield curve has preceded every recession since 1960. These include the recessions of April 1960-February 1961; December 1969-November 1970; November 1973-March 1975; January 1980-July 1980; July 1981-November 1982; July 1990-March 1991; and the current recession. The only time recession did not occur following inversion was in 1966-67.

Interest rates are crucial to businesses creating jobs for the economy. The yield curve is perhaps the most important market-based indicator of where interest rates are heading. It is also a powerful indicator of expectations regarding recession, economic expansion and inflation. A 1990 Federal Reserve Bank of New York report observed, "It suffices that the yield curve can predict future macroeconomic developments without necessarily causing them." Arkansas is part of the St. Louis Fed district, which published an October 1997 essay on the subject, 'Yielding Clues About Recessions: The Yield Curve As A Forecasting Too.'

Industrial production has never contracted for more than four consecutive months since 1960 without recession taking place. Industrial production is one of four indicators used by the Cambridge, Mass.-based National Bureau of Economic Research to formally call a recession. It contracted for 11 months in 1960; eight months in 1969-1970; six months in 1974-75; five months in 1980; six months in 1981 and 10 months in 1982; and six months in 1990-91.

Industrial production is a monthly government report that provides a fixed-weight measure of U.S. physical output from factories, mines and utilities. It ranges from the production of automobiles and trucks to computers, clothing, household appliances and furniture. The largest component is manufacturing output.

At the time Policy Foundation representatives met with Gov. Huckabee and his staff Feb. 1 the yield curve had inverted (June 2000) and industrial production was finishing its fourth consecutive month of contraction. Starting in October 2000, industrial production has fallen for 12 consecutive months, the longest decline since the 1930s.

Legislative Oversight

The stakes involved in preparing multi-billion dollar government budgets are enormous. Mistakes are costly and affect the lives of Arkansas' 2.8 million citizens, ranging from students in the K-12 system to the police personnel who protect law-abiding citizens.

Early warning of recession called for a more realistic assessment of revenues and spending, a path not chosen by the Huckabee administration, which increased spending imprudently. Arkansas can do better if lawmakers learn from the DFA's mistakes by creating an economic early warning system that serves as a model for states in the region. Under such a system, inversion of the yield curve and contraction of industrial production would serve as warning signals about the economy, state revenues and spending habits.

Legislators wishing to exercise their oversight responsibilities might consider the yield curve and industrial production data. Available for free to legislative staff, and discussed at length in Federal Reserve publications, they provide legislators a powerful tool for understanding the real economy.

 --Greg Kaza